2 November 2008
Bruce R Bent, founder and chairman of the New York-based cash management firm The Reserve, is in a spot of bother at the moment.
The 71-year-old American, widely credited with having invented the money market fund in the 1970s, has finally started paying back investors in his Reserve Primary Fund, from which there were billions of dollars of panic withdrawals in the immediate aftermath of the Lehman Brothers collapse on September 14th. And, at most, the investors are getting half their money back.
Reserve Primary was a big buyer of holdings in credit arbitrage funds or “conduits”. During the credit bubble years such funds were deeply fashionable. These are complex and opaque vehicles created by banks, which gave them deliberately obscure names. In addition to profiting from borrowing short on the commercial-paper market and investing long in opaque credit derivatives such as collateralized debt obligations, the funds enabled banks to park loads of dodgy credit issuance off balance sheet.
The ruse made it possible for banks to enhance their lending capacity without any need to increase the risk-weighted assets on their balance sheets (which they would otherwise have been required to do by regulators under Basel II regulations). Before the credit bubble burst, regulators turned a blind eye to such chicaneries. After all, securitisation and the use of structured finance vehicles enabled the banks to reduce their risk, didn’t it? Even former Fed governor Alan Greenspan believed it, so it had to be true.
While they could, investors including Bent were happy to milk conduits for all they were worth. The vehicles offered juicy yields at what seemed like low risk. Bent and his ilk didn’t mind that conduits were backed by risky assets such as impossible to fathom bundles of mortgages, car loans and credit card receivables. Surprise, surprise, the credit ratings agencies including Standard & Poor’s and Moody’s were only too happy to slap “AAA” ratings on these conduits.
Bank of Scotland had dabbled in the residential mortgage-backed securities market (RMBS) before its merger with Halifax, having launched Mound Financing in 2000, apparently with a view to boosting its lending power without having to bother with anything taxing like increasing customer deposits.
Driven by the urge to increase its share of UK mortgage lending, Halifax Bank of Scotland went hell for leather into the securitization markets following the two banks’ September 2001 merger. In the summer of 2002, Bank of Scotland launched Grampian Funding, a €40 billion vehicle ostensibly owned by a Jersey-based charitable trust. Halifax followed suit by launching Permanent Financing a few months later.
With the housing market in overdrive, HBOS as a group became a gung-ho player in the securitization markets. The merged bank issued an astonishing £13bn of RMBS in 2003 through Permanent Financing, Mound Financing and its covered bond programme, just under half the total value of RMBS issued in the UK in 2003.
Grampian was latterly offering investors such as Bent coupons ranging from 5.04% to 5.5%. However Grampian was a much riskier bet than it seemed — or than HBOS painted it. Last year Grampian had $36.9 billion worth of asset-backed securities, including Alt-A residential mortgages (otherwise known as ‘liar loans’), on its books. There was no mention of the Jersey-registered conduit in HBOS’s 2006 annual report and accounts. Yet the bank is now bizarrely claiming that Grampian Funding has always been fully consolidated into its balance sheet.
The vehicle first entered the limelight in August 2007, when HBOS was obliged to step in to fund the $36 billion it owed and take the previously “self-funding” conduit back onto its balance sheet. Just over a year later, however, the game was effectively up for HBOS.
After the wholesale markets froze after Lehman Brothers collapse on September 14th 2008, HBOS’s share price sank like a stone, in a way that traders say was unprecedented for a “blue chip” FTSE-100 company. This was largely because investors — both wholesale funders and institutional investors in the bank’s equity — had realised that the bank had allowed itself to become so dependent on wholesale funding, which had dried up completely last September, that it had little chance of surviving as an independent concern.
It was also because it was well known in the City that the bank’s head of corporate lending Peter Cummings was a bit of an oaf who seemed willing to lend money to questionable entrepreneurs without asking too many questions about what they intended to do with it. Later that week the bank’s board effectively threw in the towel, recommending a government-assisted takeover by Lloyds TSB.
If this deal goes ahead, presumably one of the first things that the new management team, led by chief executive Eric Daniels, will be doing it taking a long hard look at Grampian.
Bent’s Reserve Primary Fund was, until it “broke the buck”, the highest yielding of all the 2,100 money market funds tracked by Morningstar. In addition to owning $1.1 billion of Grampian Funding, Reserve Primary also owned $785m of Lehman debt.